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Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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We're considering the effect of government policy on international trade. And now we're going to take a brief foray into microeconomics to look at the effect of tariffs and quotas on the international economy.
Consider a situation in which a country has a demand for a particular product, maybe this is oil, and a supply of the same product. Demand decreases as the price rises and the quantity supplied domestically increases as the price rises. Now if this were a closed economy, the price would be set at the point where supply and demand cross. But let's suppose for a moment that this is an open economy, an economy that trades with the rest of the world. And the price of this good is set in world markets and, as far as this particular small country is concerned, the world price is a given. That means you can buy all the oil that you want at $20.00 a barrel and any oil that you produce you can only sell at the world price of $20.00 a barrel, because everyone else could buy oil at that price, and therefore you can't charge more. If you have a price that's set in world markets, then your customers and your country are going to buy the amount where the world price touches the domestic demand curve, right here, the quantity demanded domestically. And this world price touches the domestic supply curve here, which tells you the amount that you're local suppliers are going to find it profitable to produce. The difference between domestic demand and the quantity supplied domestically, this is the volume of imports in your country. So people want to buy this much more oil in this small country than the producers in that small country are making. At a price of $20.00 a barrel, this is the volume of imports.
Now, international trade is a great thing, because look at all the advantage that customers get. A lot more people can afford oil in this situation than could if the economy were closed and the price were higher. So what happens now, whenever the government decides to enact a tariff or a quota, that is, to reduce the volume of trade to allow domestic suppliers to charge a higher price for their product, we have to add the tariff or the effect of the quota onto the world price. Let's consider first the tariff. A tariff is a tax on imports of this good. So if a tariff is imposed, then everyone who imports oil into this economy has to pay the world price plus the tariff on top of that. They have to pay the tariff to the government to bring the oil into the economy. That means that the domestic price of oil rises from $20.00 a barrel to $20.00 a barrel plus the tariff. Maybe the tariff is $5.00 a barrel, making the total price for oil now $25.00, if you want to bring a barrel into the country. Well, since imports are now costing you $25.00 a barrel domestic producers can also charge $25.00 a barrel for their own production, because they don't have to worry about foreign competition. The overall price of oil in this economy then rises to $25.00 a barrel, the world price plus the tariff.
Now, at this higher price for oil, we get two effects: the first effect is the quantity of oil demanded shrinks because of the higher price. So the quantity demanded domestically with the tariff is going to be less than the quantity demanded domestically originally, without the tariff. Also, now that you can charge a higher price for oil, more of the domestic suppliers are interested in producing oil and bringing it to market. So the quantity supplied domestically increases at the same time that the quantity demanded domestically shrinks. The overall volume of imports, notice, is smaller than it was before. We had a large volume of imports at the low price and a small volume of imports after the tariff is added on. Now, with tariffs, we wind up then with much less demand for imports. With less demand for imports, there is less demand for foreign currency. So the domestic currency of this country is in shorter supply on world markets. People don't need to buy foreign currency to import oil, and therefore they keep the domestic currency at home, doing their shopping and their oil purchases at home. Because there's less supply of the domestic currency, the domestic currency is going to tend to appreciate in the world markets for foreign exchange. What happens then is the tariff, by restricting international trade, creates a shortage of this country's currency in world markets. By creating a shorting of this country's currency, it leads to an appreciation of this country's currency. Remember a short supply means a higher price. Therefore, tariffs, by shrinking the engagement of a country with the world markets, by reducing the supply of that country's currency in world markets for foreign exchange, leads to an appreciation of that country's currency.
Let's consider now the way that a quota would work, because it's quite similar. The way a quota works is slightly different. Instead of adding a price onto the world price, the quota says that only a given amount is allowed to be imported into the country. So if this country put a quota on oil imports, say a quota equal to this amount right here, the amount that we wind up having imported in equilibrium, then what happens is this quota creates a shortage of oil in the country. Remember there's excess demand at the world price if the government will only allow this small amount to be imported. So what happens is the price of oil is bid up, because of the shortage, until the quota just fits comfortably between the demand curve and the supply curve. Finally, when this country is only importing the amount that the government will allow under the quota, then the price that we have is the price that gives us equilibrium. So rather than having a tariff, what we have is a new higher price in this economy, because of the artificially created shortage, due to the quota. Because the government has restricted trade in oil, the price rises in this economy. It's the same thing, it's exactly the same phenomenon. Now this country is importing less oil and, because it's importing less oil, less of its foreign exchange is going to be going into the world markets, therefore, an appreciation. So an appreciation of your foreign currency overall is going to incline foreigners to buy less from your economy. And it's going to incline people from your economy to want to spend more on imported goods in other markets that aren't being distorted by tariffs and quotas.
So these are the effects then of trade policy on the trade deficit. If the government imposes tariffs and quotas, they tend to shrink the trade deficit; however, they also tend to lead to appreciation of your currency, which is going to cause people to want to import more from other markets. So then the government may have to go in and slap tariffs and quotas on those other markets, as well. All in all, there's a connection between trade policy, the value of your foreign exchange, and your overall trade deficit. This is a microeconomic approach to the connection between government policy and foreign trade.
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International Focus
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